Monday, December 31, 2007

Wall Street braces itself for more sub-prime misery

From The Times December 31, 2007
Tom Bawden in New York

New year celebrations may not always usher in a better year. As Wall Street reflects on the misery of the past six months – the credit crisis, sub-prime losses, executive sackings and share-price slides – many say that the worst is yet to come.

As Goldman Sachs pointed out last week, Citigroup still has an estimated $25 billion (£12.5 billion) of collateralised debt obligations (CDOs) on its books, the bundled packages of sub-prime loans that are now perceived as so risky they are effectively worthless.

Merrill Lynch, which is expected to admit to writedowns of almost $12 billion in the fourth quarter alone, has about $8 billion of CDOs in its portfolio. According to Goldman estimates, JPMorgan is exposed to around $5 billion of the securities.

Even though American banks have collectively written off at least $60 billion in combined sub-prime-related securities, James Owers, Professor of Finance at Georgia State University, says that “the worst credit crunch in modern history still has some way to go yet . . . The repercussions will eventually be more widespread than the savings and loan crisis.” (This occurred in the 1980s and led to the closure of 1,000 American building societies, with the loss of $150 billion).

The bank also thinks that its rivals are unlikely to be able to hope that they can offset the misery of their sub-prime investments with revenues from investment banking and M&A, both of which it expects to stagnate in 2008.

Yet while few Americans are likely to feel sympathy with Wall Street bankers, they may worry that banks’ reluctance to take on more risk and extend credit lines to American businesses could push the country into recession. Moody’s Investors Service pointed out to clients last week: “The continued uncertainty of what land-mines remain on bank balance sheets has the potential to spill over into restricted lending to industrial firms.”

The fallout from the sub-prime mortgage meltdown has hit all lending. Private equity firms have been hit particularly hard because, typically, they finance about two thirds of each leveraged buyout with debt in high-risk deals that, in this climate, are causing the banks to balk.

The impact on private equity deals has been enormous. Some deals that were agreed before the credit crunch took hold, such as the takeover of Home Depot’s building supplies unit by a consortium including Carlyle, saw their prices cut dramatically – in that case, by $2 billion. Other deals collapsed as the private equity firms were unable to secure financing or were not prepared to complete the transaction. In October, Kohlberg Kravis Roberts and Goldman Sachs walked away from their $8 billion takeover of Harman International, the audio speaker maker. JC Flowers’s bid to buy Sallie Mae, the student lender, for $26 billion, fell through.

Risk on Wall Street

— Citigroup Tipped to cut dividend by 40 per cent and to write off $18.7bn in Q4. Expected to raise up to $10bn of new capital. Sitting in $25bn of CDO investments

— Merrill Lynch Expected to write off $11.5bn in Q4; still exposed to $8bn in CDOs

— JPMorgan Expected to write off $3.4bn in Q4; still exposed to $5bn of CDOs

Source: Goldman Sachs Note December 26 2007

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